Five Things You Need to Know: A Crisis of Faith

Financial engineering now leaves us with disproportionate risk.

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Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Sentiment Is a Confidence Game

A Reuters/University of Michigan preliminary consumer sentiment index plunged to its lowest level in 16 years in January as the Media continued its conspiracy to ruin America by reporting things that are happening.

Relax, we're just kidding. Now, it would be kind of nice if the Media really did control our (the Royal aggregate "Our") sentiment; a convenient way to wash our hands of the whole mess. But the reality is that social mood drives what we see in the Media, not the other way around.

So the Reuters/University of Michigan preliminary index of consumer sentiment decreased to 69.6 from 78.4 in January, the lowest since February 1992. The Index of Consumer Expectations, which some economists view as an indicator of future consumer spending, decreased to 59.4 from 68.1 last month. Also, inflation expectations a year out edged higher, to 3.7% from 3.4%; not good news for Federal Reserve Chairman Ben Bernanke and his stated concern over "inflation expectations remaining well anchored."

Of course, this is just the "preliminary index." What, exactly, makes this a "preliminary" survey? Mostly, the number of responses. The preliminary survey reflects 300 responses to 30 questions, while the final survey, which will be released on February 29 reflects 500 responses.

Then are these consumer surveys really something we should care about? Actually, yes. One part of the surveys - the Index of Consumer Expectations – is an official component of the U.S. Index of Leading Economic Indicators.

2. A Crisis of Faith?

Speaking of sentiment, we ran across a Paul Krugman op-ed piece today that was interesting despite his well-known Keynesian views, if only for the fact he outlined what is a central banker's worst nightmare: a crisis of faith.

Krugman writes, "Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, it's more than a subprime crisis; indeed, it's more than a housing crisis. It's a crisis of faith."

For all the computer systems, academic models and financial engineering we have at our disposal today, there remains one crucial market aspect that simply cannot be programmed away - faith. At the end of the day, all transactions still rely on the one thing that made them possible in the first place at the beginning of the day; the faith, in ourselves and others, that a fair exchange is taking place.

This is not meant to disparage the contributions made by "financial engineering"; that phrase often intended as code for "shenanigans." Not at all. In fact, it is this very micro-processing and disassembling of financial transactions that have allowed us to transform our economy, for better or worse depending upon your place in the business cycle, into something finance-based to supplant a declining manufacturing base.

The downside, however, is that this same financial engineering that made it possible to disassemble financial transactions, increasing the profitability of the sum of the parts by many magnitudes over the whole, now leaves us with disproportionate risk.

All economic bases carry risk; manufacturing, raw materials, services, finance-based. Our mistake was thinking we had miraculously chopped up our risk into tiny discrete slivers and sold it all away to disinterested parties. Now, it turns our that all those tiny slivers are actually backed by the very same thing as the original transaction itself; faith.

3. High vs. Low (Pt. II)

Yesterday in Five Things we discussed PF Chang's (PFCB), Denny's and HH Gregg in terms of the High vs. Low consumer paradigm. Looking backward at the last quarter, companies are reporting some resilience in high-end consumers even as mid-level and low-end consumers cut back and trim discretionary spending.

Increasingly, fast food companies, which traditionally cater to cost-sensitive consumers, are increasing the profile of their low-cost, low-end value menus, expanding offerings in this category and even cutting prices in a backdoor fashion by offering larger sandwiches for less.

Yum Brands (YUM) is promoting its Gordita Supreme product, one of the largest items on the menu, for a dollar this month. Wendy's (WEN) last month introduced a double cheeseburger for a dollar.

Unfortunately, this is also having the effect of squeezing margins due to ongoing commodities price increases. And this brings us to today's Number 4, Pricing Power...

4. Pricing Power: Who Doesn't Have It?

First, let's look at who doesn't have much pricing power.

Who Doesn't?

The market is clearly voting that consumer discretionary, dine-away stores do not have much pricing power, particularly on the upper end of the fast casual dining segment.

Chipotle (CMG) is down 30% year-to-date, and more than 6% today after reporting results that came in shy of estimates. I happen to like Chipotle, especially their focus on natural ingredients. But the average ticket price for Chipotle is relatively high, in the $9.50 to $10 range.

To combat rising costs, the company already has taken pricing steps in 2007 that will equate to a 1.5% menu price increase this year. To cover what the company expects to be another 50 basis points of higher food costs this year, however, there will be another layer of 1.5% increases on top of that.

On the call this morning Chief Finance and Development Officer John Hartung explained why the company believes it does have pricing power. "When we increased prices (as a test in Arizona), we didn't see any additional falloff whatsoever in transactions," he said. "We went and talked to customers and 70% of the customers said they're willing to pay more based on our Food with Integrity initiative, based on the fact that they understood that we are offering natural meat, natural beef and natural chicken."

Hartung noted that if we compare Chipotle prices to other restaurants in the fast-casual category, their menu prices are in line while their food quality is dramatically higher. That's probably true, but as risk aversion among consumers continues to spread from those faced with involuntary thrift choices and those at the upper end beginning to choose voluntary thrift, the best case may be that they capture enough trade down consumers to offset some of the 30% apparently not willing to pay more for based on their Food With Integrity mission.

5. Pricing Power: Who Does Have It?

For now, at least, consumer staples companies appear to have some pricing power. Campbell's Soup (CPB) this morning said the company expects the pricing actions it is taking will translate into significantly improved second half margins. Apparently, the market believes this to be true as the stock is up more than 7% today.

Also this morning, JM Smucker's (SJM) reported earnings and indicated they too are prepared to continue taking pricing actions throughout the year to balance out rising raw materials costs.

However, keep in mind the bulk of these price increases are still to come. Many will not be felt on the shelves until March and April. One reasonable expectation is that the pushback comes in terms of consumer tradedowns in container size and from branded labels to private labels.

Both companies separately noted that they are concerned about how consumers respond the pricing. It's not a given that pushback won't be significant. However, for CPB, at least, one thing in their favor is that the soup category led the second quarter, and soup is the quintessential recession food.

In fact, reading between the lines, CPB is gearing up more for a second half slowdown in the overall economy that will actually translate into a positive for the company. As CEO Doug Conant said on the Q&A in the company's call,"We think there's latent opportunity for that [consumers trading down]. Obviously we haven't tapped into it yet, otherwise I'd be reporting better numbers, but we think we're well positioned here, and we expect better things in the second half than we had in the first half."

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